A SIMPLE IRA (Savings Incentive Match Plan for Employees) is a retirement savings plan for small businesses with fewer than 100 employees. SIMPLE IRAs work much like traditional IRAs and are easier to set up than a 401(k), but the employee contribution limits are lower, compared with 401(k)s.
Read on to find out whether a SIMPLE IRA is the right investment account for you and your employees.
- What is a SIMPLE IRA plan?
- What are SIMPLE IRA rules?
- What are SIMPLE IRA contribution limits?
- What are the pros and cons of SIMPLE IRAs?
- Is a SIMPLE IRA right for me?
- How do I open a SIMPLE IRA?
What is a SIMPLE IRA?
A SIMPLE IRA is the small-company version of a 401(k) plan that is subject to many of the same rules as traditional IRAs. This workplace retirement savings account allows eligible employees to invest a portion of their pretax salary into an individual account and receive mandatory employer contributions.
Small businesses — generally those with 100 or fewer employees — sometimes offer workers a SIMPLE IRA plan in lieu of a 401(k) because (as the acronym implies) it’s easier to set up and administer. If you work for yourself, you’re also allowed to contribute to a SIMPLE IRA, although there may be better retirement plan options for the self-employed.
What are the SIMPLE IRA rules?
SIMPLE IRAs have many of the same investment, distribution and rollover rules as a traditional IRA. Contributions are tax-deferred, meaning the amount you save up to your contribution limit reduces your taxable income for the year, and investment growth is tax-deferred until you start taking distributions in retirement.
In other ways, SIMPLE IRAs are like 401(k) plans: Eligible employees indicate how much (if anything) of each paycheck they want to contribute to the account, and the money is automatically diverted into the worker’s individual investment account.
The main drawback for some businesses might be the fact that SIMPLE IRAs require mandatory employer contributions. Employees might like that employer match, but they may be less happy about the lower contribution limits, compared with 401(k)s, and the lack of a Roth version.
The mandatory employer contribution is what makes SIMPLE IRAs different from some other employer-sponsored retirement plans. The rules are detailed in the next section.
What are SIMPLE IRA contribution limits?
Employee contribution limits for a SIMPLE IRA in 2020 are $13,500, up from $13,000 in 2019, for those under age 50. People age 50 and older can make an additional $3,000 catch-up contribution.
Employer contributions are mandatory and can be made using one of two methods:
- Provide matching contributions up to 3% of the employee’s pay, not limited by any annual compensation limit.
- Make non-elective contributions equal to 2% of the employee’s compensation based on a maximum salary of $285,000 in 2020 (up from $280,000 in 2019).
What are the advantages and drawbacks of a SIMPLE IRA?
From the perspective of employers, these are some of the advantages of SIMPLE IRAs:
- Start-up and operating costs are generally lower than setting up a 401(k) plan.
- Employers get a tax deduction for their contributions to employees’ accounts.
From the perspective of employees, these are some of the advantages of SIMPLE IRAs:
- Employers must contribute to employee accounts, as detailed in the previous section. Employees might consider that an advantage of SIMPLE plans, but some employers may find that rule a hurdle.
- Employees don’t have to sign up for salary deferrals to get the employer contribution if your employer chooses the nonelective 2% contribution option. If your plan uses the elective salary reduction/matching method, you must contribute to earn the match.
- Eligibility requirements are low. In general, you’re eligible to participate in a SIMPLE IRA if you’ve received at least $5,000 in compensation during any two preceding calendar years and expect to earn at least that much during the calendar year of participation. But the IRS also allows employers to offer these accounts to employees who don’t meet these standards.
- Employer contributions vest immediately. With no vesting period, you have 100% ownership of all the money in your SIMPLE IRA.
- The IRS lets individuals contribute to other retirement savings plans at the same time. That’s handy if, for example, you have more than one job that offers an employer-sponsored retirement plan, or if you also want to contribute to a traditional or Roth IRA.
- Investment choices tend to outnumber what’s offered in 401(k)s. Instead of being limited to whatever mutual funds a 401(k) plan administrator chooses, you can invest in stocks, bonds, mutual funds and any other investments offered by the IRA provider.
Before you fall in love with the idea of opening a SIMPLE IRA, consider some of its shortcomings:
- Contribution limits are lower than other workplace retirement plans. In 2020, employees and solo business owners under age 50 are allowed to contribute $13,500 in a SIMPLE IRA versus $19,500 in a 401(k), and $16,500 versus $26,000 for those age 50 and up.
- There is no Roth version of the SIMPLE IRA. This is a big drawback given the benefits of Roth IRAs and Roth 401(k)s. (See “What Is a Roth IRA?” for more on why we like these accounts.)
- Participant loans are not allowed. Although we discourage dipping into retirement savings early, if you need to, the SIMPLE IRA doesn’t allow them.
- You’ll pay a steep tax penalty for some early withdrawals. In general, SIMPLE IRA distribution rules mirror traditional IRA rules, except for non-qualified withdrawals within the first two years of your participation. For those, you’ll pay an extra 15% early withdrawal penalty on top of the standard 10% penalty. That means if you tap into the money before age 59 ½ and before you’ve had the plan for two years, you’ll likely owe the IRS 25% of the money you take out in penalties, plus whatever income taxes you owe on it.
- Rollovers to another IRA or employer-sponsored retirement plan are subject to strict rules. The 25% penalty mentioned above also applies if you do a rollover into anything other than another SIMPLE IRA during the two-year period after you first participate in the plan.
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Is a SIMPLE IRA right for me?
The answer depends on whether you’re an employee or the employer.
For employees: Anyone who has access to the plan at work and wants to maximize their savings should contribute to the account. Otherwise, you’re leaving free money on the table.
If your plan provides the automatic 2% employer contribution, you’ll get that money even if you elect not to divert any of your salary. If the employer contribution is offered by matching funds, you must sign up to contribute a portion of your own salary to earn the match. (Remember: You can still save in other types of retirement savings accounts in addition to a SIMPLE IRA.)
For business owners: If you’re a solo business owner or self-employed and your goal is to maximize your own retirement savings, there are other retirement savings plans that have higher contribution limits:
- A solo 401(k) allows a business owner with no employees to contribute up to $57,000 in 2020, with an additional $6,500 catch-up contribution if you’re age 50 or older. The exception to the no-employees rule is if your spouse earns income from your business.
- A SEP IRA (Simplified Employee Pension Individual Retirement Account) is a lot like a SIMPLE IRA. But like a solo 401(k), the contribution limits are much higher: You’re allowed to contribute either 25% of compensation or up to $57,000 in 2020, whichever is less.
If you own a small business with employees, a SIMPLE IRA might be attractive if you want to offer your employees a retirement plan but would like to avoid the extra administrative costs that can come with a 401(k). Just keep in mind that some employees may still wish for a 401(k) because of its higher contribution limits.
» Read more about how to choose between a SIMPLE IRA and a 401(k)
How to establish a SIMPLE IRA
Opening a SIMPLE IRA is similar to opening a traditional IRA. However, if you’re a business owner, there are additional reporting requirements and documents you must fill out to establish the plan. Most IRA providers offer SIMPLE IRAs that you can open online.
The IRS outlines three steps for employers or solo business owners setting up a SIMPLE IRA plan:
- Pick the type of SIMPLE IRA plan you want to use by filing either IRS Form 5305-SIMPLE (if you’re depositing contributions at a designated financial institution) or IRS Form 5304-SIMPLE (if employees are permitted to choose a financial institution for the account).
- Provide eligible employees information about the SIMPLE IRA plan.
- Set up separate SIMPLE IRAs for each eligible employee using Form 5305-S or Form 5305-SA.
If you work at a company that offers a SIMPLE IRA, your employer will have you fill out one of the forms above to establish an individual account.
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